The Equity Monster is Lined-Up in the FED’s Cross-hairs

The Equity Monster is Lined-Up in the FED’s Cross-hairs

In a recent article (Past Monstrous Behavior By Equities, And One Very Scary Chart) we used the analogy of wrestling a monster in a dark room to illustrate the difficulty of predicting the equity markets. We pointed out that even though no two markets are ever the same, historical studies of past behavior can inform our probability calculations. Here, we give an update to the monster’s recent behavior.

The only true constant in the market is that it runs on emotion; it is an emotional monster, after all. This is true because Humans make the market, and Humans themselves are a bag of emotional monkeys. The difficulty with this line of thinking, however, lies in the fact that for the last decade, machines have been making the market, not Humans; 70% of trading is machine based. Yet, the market seems to continue trading on emotion. Why is that?

One possible explanation is that most of the algorithms that are employed in trading are designed to look for patterns in the market that have a high probability of repeating. These repetitive patterns, that the machines learn to identify and to trade with, are in fact mostly proxies for Human behavior since, until recently, it was Humans who made the market. So, inadvertently, the neural networks that are used by machines to learn how to trade, wined-up trading by mimicking what emotional Humans have done in the past, only much faster. This is a plausible explanation for why sentiment indicators continue to be useful in understanding even this machine age market.

This week, the FOMC minutes revealed a plan to force-feed the market a rate hike, perhaps as soon as this coming June. The CME Fedwatch tool calculates a 53% chance of AT LEAST one hike by the end of July. This, of course, yanked the monster’s chain, causing it to flail around for a couple of days before recovering enough to finish in positive territory for the week. Now that the monster is in the FED’s cross-hairs, it will be hard for the market to relax, and this increases the chances of bad behavior.

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Forty years of private equity trading, and still learning.

Forty years of private equity trading, and still learning.